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Preferred Securities: High Prices Likely Mean Lower Returns

High preferred securities prices mean that the strong returns to start the year are unlikely to continue.

Preferred securities’ yields have fallen sharply this year, following the trend of long-term Treasury yields. The drop in yields has pulled up prices to their highest levels since late 2017. With prices so high, total returns going forward are likely to be relatively low.

So what’s an income-oriented investor to do? With prices so high, today’s entry point no longer looks attractive. We would not initiate new positions in preferred securities or preferred security funds at current prices, nor would we suggest adding to positions. For those who currently hold preferred securities, maintaining those positions may still be appropriate given the higher income payments they provide. If prices continue to rise, however, it might make sense to reduce exposure.

What are preferred securities?

Like bonds, preferred securities have fixed par values and make scheduled coupon payments throughout the year. Preferreds often make quarterly payments, instead of semiannual payments like traditional bonds do. They are usually issued with maturities of 30 years or more, or they may be perpetual, meaning they have no maturity date at all.

Like stocks, however, preferreds rank very low on an issuer’s priority of payments, for example in the case of bankruptcy. Preferred securities generally rank below an issuer’s traditional bonds, but they rank above the issuer’s common stock—hence the name “preferred.” Their coupon payments are often discretionary, meaning they can be suspended without triggering a default, unlike the way a missed payment on a traditional bond would. A benefit of many preferred securities—specifically those of preferred stock—is that the coupon payments may receive advantageous tax treatment, such as eligibility for qualified dividend income treatment.

Preferred securities are often rated by credit rating agencies such as Standard and Poor’s or Moody’s Investors Service. However, the rating for an issuer’s preferred security is often lower than the rating on the issuer’s bonds.

Because of these complex characteristics and increased risks, the yields on preferred securities tend to be higher than other fixed income investments. The average coupon rate of the ICE BofAML Fixed Rate Preferred Securities Index is 5.7%, above most investment-grade bonds.

Higher prices mean lower returns are likely

The high coupon rates don’t tell the whole story, however. Prices have risen sharply since the end of last year. After dropping sharply in the second half of 2018, preferred security prices have surged in 2019, helping the ICE BofAML Fixed Rate Preferred Securities Index deliver a year-to-date total return of more than 14%.1

Preferred securities’ prices are at 20-month highs

Source: Bloomberg, using weekly data as of 8/30/2019. Past performance is no guarantee of future results.

Like most investments, the price at which you invest matters. Historically, with prices as high as they are today, total returns over the subsequent year or so have been low compared to other starting prices.

The chart below breaks down the average 52-week total return of the ICE BofAML Fixed Rate Preferred Securities Index, broken down by average starting price cohorts. The average price of the index is now above $105, a starting point that has historically led to the lowest average returns.

Keep in mind that these are simply averages—returns can be higher or lower than what’s shown in this chart. But with prices as high as they are today, investors should manage their total return expectations accordingly. Total returns going forward are unlikely to be as high as they’ve been to start this year, and there’s a lot more room for prices to fall than to rise.

Today’s average prices have historically led to relatively low total returns going forward

Source: Schwab Center for Financial Research and Bloomberg. Forward 52-week total returns of the ICE BofAML Fixed Rate Preferred Securities Index using weekly data from 5/5/1989 through 8/30/2019. Past performance is no guarantee of future results.

Three key risks

Preferred securities have three key risks:

1. Interest rate risk, or the risk that an investment’s value will fall if interest rates rise. That’s because the prices and yields of fixed income investments generally move in opposite directions. Because preferred securities have very long maturities, or no maturities at all, they are very sensitive to changes in long-term Treasury yields.We expect yields in the U.S. to stay low due to global growth concerns and the likelihood of additional rate cuts by the Federal Open Market Committee. There’s also more than $16 trillion in negative yielding debt across the globe, which can keep domestic yields from rising much from current levels. With 10-year yields now near 1.5% and not far off the all-time low of 1.32% from 2016, we don’t see much room for yields to fall further.

2. Credit risk, or the risk that an issuer can’t make timely coupon or principal payments. Because preferred securities generally rank below an issuer’s bonds, and because their coupon payments are generally discretionary, they have elevated credit risk.

Credit risk could come to the forefront if the economy were to take a turn for the worse. Corporate profit growth has been slowing. According to FactSet, S&P 500® earnings declined by 0.4% year-over-year in the second quarter of 2019, and negative growth is expected in the third quarter as well. Declining corporate profits can make it more difficult for issuers to make timely interest and principal payments.

3. Call risk is the risk that a security is redeemed (or “called”) prior to maturity at an unfavorable time, such as when interest rates are low.

Preferred securities are often “callable” by the issuer. That means the issuer can retire the preferred at a given price (usually its $25 par value) after a certain period of time has passed (usually 5 or 10 years).

Call risk is a significant risk given today’s low interest rate environment. Many preferred securities that are currently callable or that have a call date approaching, trade with negative yields-to-call.3 In other words, a preferred security may have a price above its par value with a call date approaching. If an investor were to purchase this security at a price above its $25 par value, and then it was called shortly thereafter at its $25 par value, the total return could actually be negative.

This can have implications for investors who own individual preferred securities as well as those who invest through a mutual fund or exchange-traded fund (ETF):

If you invest in individual preferred securities, always take note of when the next call date is, especially if the price is above the $25 par value. Although the “current yield” will be positive, the yield-to-call can still be negative.4

If you invest through a mutual fund or ETF, this may simply limit the potential for capital appreciation. Some fund managers may try to limit exposure to preferreds with negative yields-to-call, but they don’t necessarily need to. The presence of a call option can limit the potential upside of preferred securities (or funds that invest in them). Rather than enjoying all of the benefits of the inverse relationship between yields and prices, the presence of a call option leads a preferred’s price to become somewhat tethered to that $25 par value.

What to do now

Lower your return expectations for preferred securities. Given the high prices today, it’s unlikely that total returns going forward will be as strong as they’ve been through the first 8 months of the year. For investors considering preferred securities today, there may be better entry points in the future. For those investors who hold preferred securities today can still do so, but if prices continue to rise it might make sense to reduce exposure.

Most importantly, be prepared for bouts of volatility and make sure you have a long investing horizon to ride out potential price fluctuations.

1 Source: Bloomberg. Total return of the ICE BofAML Fixed Rate Preferred Securities Index from 12/31/2018 through 8/30/2019 was 14.65%.2 Source: FactSet, “Earnings Season Update: August 30, 2019.”3 Yield-to-call measures the annual rate of return on a bond assuming that the bond is redeemed on the first (or next) call date. 4 Current yield simply divides the security’s annual interest payments by the price paid. However, it doesn’t tell the whole story, as it doesn’t take into account the return of principal, which happens when a bond matures, is sold or is called.

What You Can Do Next

Consider the price at which you’re investing in preferred securities, not just the high coupon payments. Preferred securities also come with unique risks, and it’s important to understand all their risks and characteristics before you invest.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Supporting documentation for any claims or statistical information is available upon request

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

The ICE BofAml Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market.

The Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.

The Bloomberg Barclays U.S. Corporate High-Yield Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The S&P 500 Index is designed to measure the performance of 500 leading publicly traded companies from a broad range of industries.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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